Statement of Cash Flows: THE statement
I read an article on Entrepreneur today about working capital and how it is a difficult concept for small business to understand. The Article lists some of the possible solutions that an owner can tap to get working capital. What struck me about the concept is the three simple things that make define working capital; accounts receivables, accounts payable and inventory. These are all concepts that are clearly articulated in the financial statement and the Statement of Cash Flows. Understanding the Statement of Cash Flows, and getting into the habit of completing a Statement of Cash Flows monthly, is an indispensable tool for small business owners. It doesn’t even have to be a complex financial analysis tool. I complete Statement of Cash Flows monthly for one of my clients on simple excel sheets, it works for the client so it works for me.
Here is a simple concept that ties Statement of Cash Flows to your working capital. If your Cash Flows are negative (more outflows than inflows) you probably do not have enough working capital to fund your operations. If your Cash flow is positive you probably do have enough working capital to fund operations. However if you are in a cyclical business you might need to borrow money from time to time. Below is a diagram on how capital should flow in a business:
Looking at the net income step we can see that capital is either left to reinvest in the business (working capital) or if no capital is left then the business operations must be financed in a different manner. If we understand the Statement of Cash Flows we understand working capital, different types of financing, reinvesting and even stockholder equity and positions (if the business has any, small businesses tend to not have any).
Typically small “lifestyle” businesses prefer to reinvent positive cash flows into the business. This is in large part because the business is maintaining a particular lifestyle. In high growth/ early exit ventures positive cash flows might be invested in a different way, usually as collateral to acquire more financing, to accelerate growth according to a predefined exit strategy. In either case to understand working capital it is essential that statements of cash flows are created on a regular basis.